Implementing Enterprise Risk Management

CHAPTER 14Risk Quantification Models

INTRODUCTION

Risk assessments, as discussed in the previous chapter, provide qualitative information with respect to the identification, evaluation, and prioritization of key risks. Risk models, the topic of this chapter, provide quantitative information with respect to the amount, shape, and sensitivity of those key risks. Risk models have long been applied in financial and insurable risk fields, such as financial risk management and actuarial science.

Risk models help manage risk by breaking it down and expressing it in mathematical terms. Models differ in methodology, assumptions, input data, and complexity, but all produce fundamentally similar output—a probability distribution or “bell curve.”

The models we'll discuss in this chapter quantify three broad categories of risk: market, credit, and operational. Strategic risk models will be discussed in the next chapter. Because statistical modeling is a highly technical subject, entire books are written on a single type of risk modeling. The purpose of this chapter is to provide a high-level overview of several commonly used models in risk management. While CROs and ERM practitioners do not need to be quants, they should have a general understanding and familiarity with the risk quantification models.

1. Market risk models examine the exposure to potential loss due to changes in market prices (i.e., interest rates, FX rates, equity prices, and commodity and energy prices). The most common ...